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FDIC's Bair drills down on how to end 'too big to fail'

Federal Deposit Insurance Corp. Chairwoman Sheila Bair gave a long speech to an international meeting of bankers in Istanbul, Turkey, today, focusing on how to end the "too big to fail" doctrine.

"In a properly functioning market economy there will be winners and losers. When firms are no longer viable, they ought to fail," Bair said. "Actions that prevent firms from failing ultimately distort market mechanisms."

Nothing new there. But Bair then got into more detail about how she would level the playing field so that even the biggest financial institutions could be "wound down" if they failed, instead of being supported by the government.

For starters, she wants to make sure that any bank-holding company would pay the ultimate price if one of its banking units collapses, even if the company operates other businesses that are still viable:

"The basic rule should be that when an insured bank fails and a receiver is appointed, the holding company of that bank and its non-bank affiliates should also be subject to resolution.

"U.S. law already allows the FDIC to use the equity of other commonly owned banks if necessary to offset the losses to the insurance fund from a failure of a related bank. This so-called cross guarantee rule should be extended to apply to the holding company and affiliated firms."

Bair also got more specific about an idea she raised last summer, regarding forcing even the secured creditors of a bank to take haircuts in the event the bank fails:

"A more far reaching proposal to consider is limiting the claims of secured creditors to encourage them to monitor the riskiness of the financial firm.

"This could involve limiting their claims to no more than, say, 80% of their secured credits. This would ensure that market participants always have ‘skin in the game.’ "

But turning secured creditors into partially unsecured creditors, Bair acknowledged, "could have a major impact on the cost of funding for companies subject to the resolution mechanism."

In other words, it could raise the potential for another credit crisis if banks suddenly became unwilling to lend to peers because of the increased risk of loss.

Finally, Bair suggested serious consideration of a British idea for bank "living wills" -- plans, drawn up in advance, that would describe how an institution would be wound down if it failed:

"To make them more effective, perhaps the approved orderly wind down plans should be uploaded on the companies' websites for the information of stakeholders.

"Secured and unsecured creditors, counterparties, and shareholders will then have full information on the effect of a wind down on their positions.

"These public plans would also serve as a constant reminder to boards of directors and managements of the consequences of their risk taking, structural complexity, and operational fragility."

But would any of this really assure that Bank of America Corp. or JPMorgan Chase & Co. would be allowed to fail?

The best defense against "too big to fail" still might be former U.S. Secretary of State George Shultz’s idea: "If they are too big to fail, make them smaller."